by Anuj Dhawan
Despite a steep decline in the value of Bitcoin and other major cryptocurrencies since the dizzying peaks of late 2021 – Bitcoin price is down from nearly ₹48 lakh just a year ago to less than ₹14 lakh today – they continue to be a topic of both high curiosity and high interest. There are still plenty of investors who believe in ‘buying the dip’ – or that the ongoing crypto crash is an opportunity to make money – never mind the continuing onslaught of bad news headlined by the total collapse of FTX last week.
Cryptocurrencies of course mean different things to different people, much like the proverbial blind men making sense of an elephant they have never seen before. An overwhelming majority of retail investors who bought into the crypto craze in the last five years viewed the latter as an easily purchasable and tradable asset that can generate quick and outlandish returns. While a few of them have made good money, most see their portfolios in deep red today.
Another view considers cryptos as much more than a get-rich-quick scheme. Economists and institutional investors have spent considerable time and effort in the last several years probing and scrutinizing claims like whether cryptocurrencies are a form of currency, or whether they are a reliable store of value like conventional assets.
Cracks have no doubt visibly appeared in several of these claims made by crypto believers and evangelists. An asset that sees its valuation rise and fall by as much as 20% in a single day can hardly be called a reliable store of value. Many economists have also often criticized the purported equivalence of cryptocurrencies with actual currencies – noting that cryptos can hardly replace fiat money as a universal means of payment or a ‘medium of economic exchange’.
All this discussion brings us the central question worth answering today: are cryptocurrencies still a good investment idea, after all the price and value erosion we have seen this year? The answer is a heavily qualified yes. In order to profit from crypto investments, we have to make use of a new lens – their relationship with central banks’ interest rates.
In a pioneering study, Sofiane Aboura, a Finance Professor at the University of Paris studied the potential influence of the Federal Reserve policy on Bitcoin price dynamics. His paper was published earlier this year and it provided evidence that the Fed Funds rate cut in March 2020 (as a policy response to the coronavirus outbreak) affected Bitcoin’s dramatic price run-up, which saw it overshoot its previous all-time high. “The main finding supports the idea that the Fed Funds rates have delayed, threshold, higher order, and spillover effects on Bitcoins,” the study concluded. In fact, plotting the price movement of Bitcoin vis-à-vis the US Fed fund rates over the past five years reveal a strong negative correlation between the two, leading us to conclude that a crypto is a put option on interest rates. What this means is that buying crypto today, or at any point in the future, would make sense if and only if the investor believes that the US interest rates will fall down in the future, and correspondingly the crypto prices will shoot up. On the other hand, punters who believe that the interest rates will go up may be better off postponing their crypto purchases.
On the other side, there are some good reasons to avoid investing in cryptocurrencies. First, the persisting global interest in cryptos has made the central banks of several countries start worrying about their possible misuse. Some countries even decided to jump on the bandwagon by launching Central Bank Digital Currencies (CBDCs). The Reserve Bank of India (RBI) is planning to launch its own digital rupee in the financial year 2022-23.
At this point in time, it is hard to say if the CBDCs will compete with the likes of Bitcoin or Ether. The Indian view on cryptocurrencies is still evolving and while the gains on crypto trade have been made taxable, crypto still presents a very high-risk trade with the ever-present danger of price volatility, liquidity, and hacking.
Also, the jury is still out on whether cryptocurrencies are a multi-generational wealth creation opportunity, but they sure are here to stay and possibly also appreciate, if one believes in the imminence of the Fed policy’s reversal (and of course the continuation of negative correlation). Finally, even if one is tempted to bet on interest rate movements via crypto investments, it is always prudent to not dabble in assets outside of one’s risk profile.
The author is the head of the investment advisory at Equipped.AI