June 7, 2023

Economic turmoil: how stagflation affects the crypto market

Article reading time:
7 min.

Economic turmoil: how stagflation affects the crypto market


Default, recession and economic crises are notthe only global financial shocks humanity faces. There is such a phenomenon as stagflation, which is reflected in the crypto market.

What is stagflation

Stagflation is commonly understood as the situation ineconomy when there is a simultaneous increase in inflation and unemployment. At the same time, the economy itself is in stagnation, that is, stagnation, or even in decline (hence the name "stagflation" - a derivative of "stagnation" and "inflation").

Typically, developing economies face onlywith the growth of inflation, caused for the most part by the nature of fiat (state, paper) money, the monopoly of central banks on the issue and, in fact, the high rate of this issue. Stagflation is a phenomenon in which central banks act similarly to high inflation, but in addition the economy itself is not growing fast enough. What can this lead to?

Consequences of stagflation

In stagflation, people are faced with the followingproblem - personal financial planning is as difficult as possible, they do not know what share of savings can be spent in the future. Inflation makes it difficult to plan and invest in the present, because no one knows what the return will be after a certain time. In addition, unemployment is rising, which causes even more uncertainty and even slower growth. In some cases, stagflation can even develop into a serious protracted economic crisis.

But how does all this affect the crypto market?

Implications for the Cryptocurrency Industry

The phenomenon of cryptocurrency exists, in terms ofhistory, for a short period of time. Therefore, there is not enough data to date on whether cryptocurrencies are a good defensive investment during stagflation and whether the stagflation period as a whole is unambiguously “good” or “bad” for the industry. To understand whether it is worth buying cryptocurrency during a period of stagflation, you can study how “traditional markets” behave during inflation or stagflation.

Stagflation (and recession with economiccrisis), of course, is harmful to any traditional markets, and cryptocurrency markets have a high correlation with well-known indices. There is a metric that reflects the correlation between the BTC rate and the S&P 500 index (for example, from early March to mid-May 2023, their correlation
was positive).

Economic turmoil: how stagflation affects the crypto market

Source: app.intotheblock.com

Note: the value of the correlation coefficient is in the range from -1 to 1.

This means that negative moods canseep from traditional financial assets into cryptocurrencies. Moreover, the times when cryptocurrencies were the object of interests of individual enthusiasts, and not large hedge funds, are long gone. Large institutional investors in our time adhere to a risk diversification strategy with a portfolio component in digital assets.

Usually in conditions of financial uncertaintyinvestors prefer easy-to-predict instruments with low volatility. Purpose: not so much the increase of capital as the preservation of savings. Cryptocurrency, on the other hand, is highly volatile, so the demand for it (especially for extremely volatile altcoins like modern memecoins) may be less than usual. Stagflation harms the cryptocurrency markets and the industry as a whole by reducing the interest of retail investors in buying electronic decentralized money. High inflation directly affects the amount of free money people have, including for buying cryptocurrency. Let us also recall the growth of unemployment, when the horizon of investment planning is significantly reduced for a banal reason: if a person loses his job, he must have savings on hand that will allow him to “keep afloat” for some time. In this sense, prolonged periods of correction (also known as "crypto winters") clearly run counter to the interests of the investor.

Pros of Cryptocurrency

However, individual financiers and playerscryptoindustries prefer investments in cryptocurrencies related precisely during the period of economic instability against the backdrop of a protracted correction. An example is individual mining companies that increase their positions during the crypto winter and their investors / creditors who are in no hurry to demand back their invested funds, counting on high returns in the future.

Choosing to invest in similar assets insteadtraditional financial instruments is due, among other things, to the fact that cryptocurrencies work on the blockchain and are not tied to the monetary policy of a particular country. When inflation rises in that particular country, investors can still benefit from the profits made by investing in cryptocurrencies. Even if their national currency loses value due to inflationary pressures.

Investors are often looking for ways to protect their savingsfrom stagflation. This is especially true in countries such as Venezuela or Argentina, where hyperinflation is often observed - a rapid and uncontrolled rise in prices for vital goods and services. Here, investments in cryptocurrency work well during periods of economic instability, as they represent an alternative means of payment. And despite their volatility, they turn out to be more stable and predictable, in comparison with rapidly depreciating banknotes. Residents of such regions can try to find a solution to their problems by redirecting part of the reserves to BTC.

Crisis and Bitcoin

Since stagflation is accompanied by highinflation and economic recession, BTC can, with some reservations, be considered as a means of protecting against inflation and at the same time as a risky (volatile) asset, the price of which can also fall during an economic downturn.

BTC in this sense is often compared to gold,traditionally served as a hedge against inflation. Why does the first cryptocurrency even claim the status of insurance against inflation? First, bitcoin is a decentralized global means of payment that is not controlled by the central authorities. Governments do not have direct control over issuance and transactions, which makes bitcoin less susceptible to monetary policy. In addition, BTC is a scarce asset, as no more than twenty-one million of these digital coins can enter circulation. BTC is sometimes referred to as a “deflationary currency” because the maximum supply is programmatically limited and the rate of influx of new coins into the economy tends to decrease due to halving.
More than 92% of the total coins have already been mined.

Because of this scarcity, bitcoin is also called"digital gold". As a rule, the prices of risky investments fall when interest rates rise. Since the cryptocurrency market has developed a significant correlation with the stock market, a lot will depend on whether BTC can break its correlation. This process is likely to take longer given the widespread adoption of the asset.

Stagflation (or major crisis) hypotheticallycan become a catalyst for the adoption of BTC and other cryptocurrencies by society, some experts are sure. Among them is Bloomberg Senior Commodity Analyst Mike McGlone, who believes that in the future, bitcoin will be a “conditionally risk-free asset” amid the problems of traditional financial institutions. And former MicroStrategy CEO Michael Saylor is convinced that BTC has already “outperformed all assets in the stock market.”

This can happen if it turns out that "debteconomy" is not viable in the long run. The tipping point may come when public confidence in BTC exceeds confidence in the current economic system. It is worth noting that the first cryptocurrency appeared at approximately the same time as the mortgage crisis in the United States (which turned into the global financial crisis) and could not become a massive “protective tool” for objective reasons. On the other hand, on the horizon of recent years, there are not enough significant global economic crises in the world (with the exception of the consequences of the pandemic), and BTC is only increasing its turnover, capitalization and popularity. This probably explains the gradual nature of the adoption of bitcoin as a defensive tool.

This material and the information in it does not constitute individual or other investment advice. The opinion of the editors may not coincide with the opinions of the author, analytical portals and experts.