CRYPTOCURRENCY & THE LOOMING RECESSION: Part I

The late 2000’s were economically turbulent times in many parts of the world. The collapse of the U.S. real estate market prompted a global financial crisis, with the effects trickling into financial markets and systems. This crisis, nicknamed the Great Recession, was declared as the most significant international economic decline since the Great Depression of the 1930s by the International Monetary Fund. As we all know, in the second decade of the 21st century starting in 2010, world economies rebounded and paved the way for healthy growth and expansion.

Around this same time was the birth of Bitcoin as the first cryptocurrency. At that point, Bitcoin was hardly known in any financial industry. Those who understood the values brought by Bitcoin, such as decentralization, transparency, and the technology vested in blockchain, worked in a close knit community over the next several years and are a major reason why Bitcoin is the largest cryptocurrency to date. Perhaps they also saw Bitcoin as an asset that could potentially counter many of the woes from the global financial crisis they had just experienced. Since cryptocurrency’s inception, the market has not faced a global recession or period of worldwide economic downturn. Recently, many financial experts are sensing a recession which may impact international economics in the next several years. On top of this, indicators commonly associated with recessions are pointing to a deceleration in growth factors.

Only time will tell when the next global recession will hit. When it does, the cryptocurrency market and industry will experience its first test against greater economic forces. How it will react is to be determined…

 

INFLATION’S EFFECT ON RECESSIONS

There is a saying that goes, “Two things are certain in life — death & taxes.”  Economists would like to add a third item to that list: inflation. While low levels of inflation can be healthy for an economy, a higher dose of inflation can lead to several negative economic effects. There are a plethora of factors affecting how a recession manifests itself in a financial ecosystem. When the price of goods and services are inflated beyond growth in wages and outside of a healthy increase, several things happen. First and foremost, consumers purchasing power is diminished forcing them to spend money more frugally. On a larger scale, this decrease in spending can translate into lower GDP and a growing rate in unemployment as those two factors are positively correlated. This vicious cycle contributes to recessions globally and although it is fixable through prudent monetary policies, it is hard for a country to negate or immediately halt the effects of a recession on its markets. Stock markets plunge, real estate depreciates, exchange rates are in flux, world trade is strained, and naturally, the economy will correct to a level of sustainable growth over the next several months. Inflation is a powerful force and now its precursory contributions to a recession will also affect the cryptocurrency market.

 

ASSETS CLASSES THAT HOLD THEIR VALUE DURING A RECESSION

During a recession, investors and consumers are traditionally more risk averse. Leading up to a recession, savvy financiers may reduce their positions in riskier assets that are more susceptible to economic turmoil to decrease the chance of portfolio depreciation. What to convert these assets into is the million dollar question. This is where “safe haven assets” come in to play. There is no universally accepted definition of a safe haven asset – it could mean an asset with low risk or high liquidity, a hedge asset, or a rainy day asset (McCauley and McGuire (2009)). Identifying a safe haven asset can depend on the spot price, time of purchase, asset converted, and several other factors but ultimately, a safe haven asset will provide the investor with a less risk averse position and a stronger asset comparatively. Below we will discuss assets that have been proven to hold their values more than others during times of financial crises.

Gold: Gold’s value is derived from resource scarcity, global economics, and a bevy of factors that have continually fluctuated over the last hundred years. While gold is not a sure-shot good investment, it can be a hedge against inflation and also a good hedge against fiat currencies during economic uncertainty. A primary reason gold is seen as a safe haven asset during a recession is because of its negative correlation (negative beta value) to the stock market. During a recession, stock markets oftentimes plummet with a majority of assets depreciating in value along with it. Gold’s inverse correlation with the overall market provides a hedge against this scenario. During 5 of the last 7 recessions dating back to 1965, gold reported positive sessions and outperformed the stock market each time; from 2005 to 2011, gold outperformed the S&P500 6 out of 7 times! Gold’s inverse correlation with the stock market creates a situation where it can become a safe haven asset during times of financial crises.

Major Fiat Currencies, specifically USD, JPY, CHF: It is no surprise that fiat is regarded as a safe asset class when economic uncertainty is rife. While a stock or bond may lose value overnight, fiat currency is traditionally one of the most stable assets and the most liquid. During times of a recession, however, fiat currency is not immune to the economic factors sparking depreciation in the stock market, bond market, and commodity market. In countries where the recession is more prominent, the local fiat currency may depreciate slightly against other major world currencies. This is where exchange rate becomes very important during times of a financial crisis — globally or on a smaller yet international scale. Predictability of exchange rate fluctuations during a global recession is hard to pinpoint. From examining several previous recessions, some trends can be identified:

  • During times of less risk aversion, the USD tends to appreciate against almost all other currencies
  • During times of high risk aversion, the USD tends to depreciate against the yen (JPY) and the Swiss franc (CHF)
  • During times of high risk aversion, the USD tends to appreciate against smaller currencies in emerging markets

While these trends are consistent with the Asian financial crisis of 1997-1998 and the fallout of the Russian debt default in August 1998, they are magnified in the Great Recession from 2007-2009. This could be because much of the global recession these years stemmed from a failing US economy and weak US dollar.

 

HOW DO YOU FIND THE SAFE HAVEN ASSET?

To come full circle, traditional fiat currencies provide a highly liquid and less risk averse position when compared to many asset types. In instances of a recession, certain currencies, such as the USD, the yen, and the Swiss Franc, stand out as safe haven assets to investors, financiers, and consumers alike. Which asset(s) you target as a safe haven will be dependent on your asset holdings including native fiat currency, your economy’s market status, and recession specific variables. For those who have abandoned their native fiat currency in favor of other world currencies or those who operate internationally and are not tied to one economy, there are fewer factors for which you have to account for in order to find a safe haven asset. Let’s examine some of the trends from the Great Recession that were much more pronounced than those around the late 20th century.

  • Market participants tried to hedge against the appreciation of other currencies to the USD, specifically the CHF and JPY amongst other major currencies.
  • Market participants sought to hedge against depreciation of smaller currencies and currencies in emerging markets vis-à-vis the US dollar. This can be seen below in the graph as the AUD and the ZAF.
  • As volatility rises in international fiat currency markets and exchange rates fluctuate, the euro, the Swiss franc, the yen, and other major currencies strengthen against the dollar.

To successfully identify which fiat currency(ies) represents a safe haven asset during a recession, one must examine the above factors to hedge against depreciation of their fiat holdings. Look for currencies in established markets that are strengthening against the rest of the market as demonstrated by their exchange rate movements.

 

CRYPTOCURRENCY AS A SAFE HAVEN ASSET?

As discussed previously, the cryptocurrency market has not endured the effects of a global recession. Opinions of how cryptocurrency will react during a time of financial crisis or a global recession are mixed from the top of the industry experts down to everyday cryptocurrency traders and blockchain enthusiasts. During times of a recession, risk aversion is traditionally higher in individuals and business commerce. Risk aversion and cryptocurrency do not mix well — currently the cryptocurrency market is notoriously one of the most volatile markets in the world. This would suggest that the cryptocurrency market may perform poorly during a global financial crisis.

On the other end of the spectrum, the cryptocurrency market presents unique types of currencies that are not governed by economies, traditional exchange rates, and boast the benefits of added security and traceability through blockchain technology. These characteristics may appeal to may consumers and investors who may lose faith in big banks if they fail again. This general separation from international economies provides hope to many that the cryptocurrency market would strengthen during financial crises if market adoption increased.

Will some of the largest cryptocurrencies (BTC, ETH, LTC, etc.) display similar trends in a recession to “safe haven” currencies like the USD, CHF, and JPY? How will stable coins that are tied to fiat currencies react during a recession when exchange rates fluctuate wildly and unpredictably? Does one cryptocurrency stand out as a clear leader to be a safe haven asset during a global financial crisis? These questions are impossible to answer definitively, but with due diligence we intend to examine what the future may hold for cryptocurrencies during a global recession.

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David Eisenhauer
David Eisenhauer

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