How Bitcoin Is Valued, Similarities to Gold, and Fed Policy Implications
Bitcoin (BTC-USD) is heavily influenced by a combined inflation derivative that I call the “Required Return” or “RY” (explained below) and the Treasury Inflation-Protected Security (TIPS) return (term of 5 years used here). So the yield displayed on the left in Chart 1 is a derivative of expected inflation – (minus) the 5-year yield on TIPS (a negative yield eventually adds up).
It’s abundantly clear that this relationship has held since 2017 and has deepened with both the peak of this combined return and the value of Bitcoin itself.
While investment flows and commercial usage certainly have effects, this is compelling evidence that real yields and expected inflation are the primary drivers of Bitcoin (shown in blue in the chart below) and, as we will see, the valuation of gold.
How Real Yield Becomes Unreal and Inflation Spikes Thanks to the Fed
Chart 2: 5-year TIPS yield versus Fed assets:
There is a clear inverse correlation between the change in Fed assets and the TIPS yield (real yield) in the three leftmost circled periods. After a brief spike in yields during the initial stages of the 2008 financial crisis, when expected inflation turned massively negative and the Fed purchased trillions in depreciated financial assets, TIPS yields began to fall. plummeting into negative territory as the Fed increased its holdings of assets (buying distressed loans with created money going to capital markets that otherwise would have seen trillions of capital destroyed).
As asset holdings stabilized and began to decline as a proportion of real GDP, real output began to recover until government and Fed actions in response to the Covid crisis that have resulted in the injection of several trillions of created dollars into the economy – but this time mainly to consumers; and therefore in an expendable form.
Real return behavior represents the effect of capital creation in excess of real GDP, which, of sufficient magnitude, cannot generate a positive real return.
Chart 3: Fed assets and money supply
The difference in impact on M2 between the monetization (purchase) of depreciated assets by the Fed during the 2008 financial crisis and the direct injection of money into the hands of consumers during the current Covid crisis is very evident by looking at this latest and greatest Fed assets jump accompanied by the peak of M2 since 2019; which was not seen during the financial crisis; and why inflation was apparently unaffected during the financial crisis (in fact, it was because the Fed prevented the deflation that market forces would have properly driven). Simply put, the newly created money is passed directly into a usable form: M2.
Chart 4 shows the St. Louis Fed proxy M3 + consumer credit (similar behavior to M2) as a ratio of real GDP to CPI; both pegged at 1 in 1960. This demonstrates that inflation is primarily and enduringly a monetary phenomenon and is always caused by Treasury and Fed policy.
As recently as mid-January 22, M2 was up month-on-month by more than 1%; implying an annual rate of more than 12%; which if maintained even in the face of real GDP growth of 4-5% (very unlikely); would lead to inflation of 7 to 8%.
Implications for Bitcoin and Gold
If the Fed continues its policy of shrinking its balance sheet and the government does not again demand that the Treasury pump money into the hands of consumers, then the yield on TIPS will move into positive territory; dramatic price drop; nominal bond yields will rise as the real yield rises; prices also down sharply. (Chart 2) The rise in the nominal yield is currently entirely driven by the rise in the real yield, since inflation expectations have remained relatively constant (5-year nominal treasury – the TIP5 yield).
Bitcoin shares a key attribute with gold: limited supply (finite in the case of Bitcoin; supply increasing at the rate of population growth in the case of gold). These characteristics mean that real GDP growth is generally greater than growth in the supply of Bitcoin and gold; unlike fiat currency where supply growth exceeds real GDP growth. Inherently, per unit of Bitcoin and gold, real GDP increases; which can be considered as an inherent real return. Holding fiat money is a negative real return equal to the rate of inflation.
Here is a derivative of expected inflation that I will call the “required return” (RY), which is the after-tax, after-expected inflation return that returns a constant equal to the expected long-term real GDP per capita growth.
RY = [(expected inflation rate (nominal 5 year Treasury – TIPS 5 or St. Louis Fed expected inflation series) + long term expected real per capita productivity growth (2% before mid 2020 and 1% since)/(1 – effective personal tax rate)]. Example: (2.7% expected inflation + 1% – (-1.16)% TIPS 5 return)/(1-0.2) = 6.1%… where 0.2 is a rate of 20% effective tax on long-term investments.
The mapping of this yield against the Bitcoin price is shown in Chart 1.
Gold faces the same two headwinds: the prospect of a higher real TIPS yield (higher real yield on cash and bonds) and potentially lower expected inflation.
Chart 5 shows the well-known recent inverse relationship between TIPS yield and gold prices, a trend that began during and after the 2008 financial crisis, but did not continue before.
Chart 6 shows the performance of gold against the RY-TIPS 5.
This shows that gold moves inversely to both the expected rate of inflation and changes in real output that deviate from long-term growth in real per capita productivity. Since the real return is subtracted from the inflation-based required return in the first formula, a negative real return adds to the resulting combined return.
A much more complete analysis and derivation of gold valuation over 200 years of gold and fiat monetary standards can be found in my Journal of Investing article.
Both bitcoin and gold move inversely with actual yield and expected inflation and their price movements can be predicted based on these expectations. Both face the same headwinds heralded by Fed policy.
The reason for this is that both gain an inherent real return which is priced higher when either the return on money declines via inflation or the real return on financial assets declines since their inherent real return is unaffected. The reverse is true when inflation expectations fall and/or the real return rises.