Geoffrey Smith

Investing.com — It is difficult times for prophets who offer alternatives to the US dollar.

After nearly two years of furious money-printing to keep the U.S. economy going through the pandemic, it seems that the U.S. Federal Reserve is becoming more and more open to aggressive measures to defend the value of the world’s reserve currency.

That’s bad news for all those who have bet that the pandemic would herald the final debasement of fiat currency. Cryptocurrencies, led by , are more than 40% off their highs of last year, while – the more traditional ‘store of value’ asset – is down nearly 10%. And the news – for them at least – is likely to get worse before it gets better.

Inflation hedges perform best not when is inflation is highest, but at times when the central bank is perceived to be furthest ‘behind the curve’, too slow in stopping a chain of events in which wages and prices chase each other higher.

That moment surely passed when Fed Chair Jerome Powell told Congress at the start of December that it was “time to retire” the word “transitory”. The central bank believed previously that pandemic-generated consumer price distortions would resolve themselves within a shorter time frame than it took to increase interest rates to affect the economy.

Since December at the latest, the Fed has been in catch-up mode, talking tough to persuade the market that it won’t let the dollar lose its value. Powell told the Senate at the confirmation for his second term at the Fed on Tuesday that he won’t let inflation become . This message is far more important than December’s 40-year high in U.S. inflation.

Markets have only begun to reluctantly accept these commitments as a matter of fact, but they are beginning to compensate for the time lost. Fed data shows that market expectations of inflation in five years’ time peaked at 2.4% in October. By the end last week, they had fallen to 2.15 %.

Bitcoin’s underperformance against gold in this time – after an equally sharp outperformance in the previous 12 months – has led many to conclude that digital currencies are not hedge assets at all, but rather risk assets, which move more in line with equities and other speculative investments.

A note was sent to all clients Monday. Morgan Stanley Sheena Shah, an analyst at NYSE: pointed out that Bitcoin trades with a positive correlation 0.34 to over the past six months. (A correlation of 1 would indicate perfect overlap). However, it tends to move in opposite directions to gold. Here, the negative correlation was 0. 

Shah illustrated that Bitcoin in particular looks most closely correlated to global M2 money supply – a relationship that has held consistently over the last eight years. It is clear that crypto has been affected by tightening monetary policy at a time where central banks account for over half the global money supply.

Anyone who bought crypto to diversify their risk may be frustrated by this, but portfolios have become much more leveraged in recent years due to central bank free money. Only the U.S. Financial Industry Regulatory Authority, FINRA has been able to track margins since the outbreak of the pandemic. They have risen by 63% over the past two years to $920 billion. Higher interest rates squeeze raise the cost of holding any assets through leverage, and crypto – without coupons or dividends to generate returns – is particularly vulnerable to such squeezes.

Gold is no exception to this. Analysts at JPMorgan (NYSE:) reckon it will be back at $1,520 an ounce – some 16% below current levels – by the final quarter of this year, as rising real yields incentivize switches into income-generating bonds.

The difference, however, is that gold’s use case is so much better established. World Gold Council data suggest that the two big categories of end buyers – jewelers and central banks – both reverted to being net buyers in the latter part of 2021. Indian jeweler purchases rose to above pre-pandemic levels in November, while China’s gold imports hit their highest level since 2019 in October. In November, the net purchases of gold by central banks in advanced economies was unprecedented since 2013.

The use case for Bitcoin, as we’ve argued here before, is altogether less convincing. The only functions for which it consistently out-competes fiat currency in ease of use are – even now after a decade of rapid and well-funded innovation – for illicit transactions, such as ransomware attacks and money-laundering. The short-term market is governed by momentum (or speculation).

Better regulation and an expanding ecosystem of related assets, such as NFTs, may allow crypto to have a wider use case. This will put a higher floor beneath its valuation. Generational shifts may also mean that that segment of the population that just doesn’t trust banks and central banks will in time migrate away from Keynes’ ’barbarous relic’ to digital assets.

In the short-term, however, neither asset appears to be performing particularly well. It can only be stated that cryptobros have a greater downside risk than gold bugs. However, the upside is less likely for them. Crypto is set to face a new tightening cycle that will test it, but gold has stood the test of time since before the dawn.