Deflation and Bitcoin
What with recent developments in geo-political events, and the sabre-rattling of the Fed to raise rates over the course of 2022, deflationary forces, or should I say expectations, once again cast a shadow over the recent appreciation in asset prices. This article will enquire into the ramifications of this for Bitcoin prices, and whether it be reasonable to think that deflationary expectations could be catastrophic as is feared by some. I’ll split the article into three parts, where first I’ll provide a reminder as to why simple narratives [and especially those along the lines of monetarist theory] are superfluous to TA [analysis of price action in the market]. I’ll then look at how these theories might in turn affect market psychology/ expectations, and how this in turn could affect price [a ‘fundamentals’ focusing more on the psychology of the market]. And lastly, I’ll bring it back to the chart, and look to identify the price ranges in which inflationary and deflationary expectations may play out. It will be my intention to show how the model of the logarithmic growth curve [LGC] can well absorb both.
1] TA Brackets out the Narrative
In conventional terms, Bitcoiners [yes, Bitcoiners also have conventions] have understood Bitcoin to have risen on the back of a narrative based on hyper-inflation. As the well-known theory goes, with the expansion of central bank balance sheets, and the enormous increase of money supply, a flood of excess liquidity will find its way into asset prices. With investors understanding inflation to be always and everywhere a monetary phenomenon, monetary value will flee conventional currencies into appreciating assets… which rise in nominal terms as money increasingly moves into them. In this scenario, Bitcoin is understood as the asset par excellence, and so conceived to be a major beneficiary of monetary value as inflation expectations snow-ball. This is the theory, based as it is on monetarism, and yet, as so often is the case, theories tend to become problematic in the face of reality. The reality is there’s trouble in the monetarist’s paradise [of theory… which tempts the uncertain with certainty]. The trouble is deflation has come to rear its head yet again after having supposedly been banished by sound monetarist policy. For those that banked on the narrative of hyper-inflation, and Bitcoin as a hedge against it, then even the possibility of the opposite happening is alarming. Was not Fed policy going to cause [hyper] inflation, and yet deflationary forces still exert themselves to remain hanging over the market like the sword of Damocles.
Of course, pragmatic and somewhat skeptical market participants, that always took as their cue for buying or not actual price developments in the marketplace, are going to be a lot less perturbed at this development. This is due to the fact that technical analysis brackets out all narrative and focuses solely on price action. The justification of buying for technical pragmatists is not a well-thought-out and convincing narrative, but a historically existent trend. Why? Because being familiar with market history, they are also only too familiar for the speculator’s capacity for self-deception [given the realities of human nature]. Whereas there is hardly any restraint or correction on our desire to believe an extremely attractive narrative, the chart itself provides the correction for this. Indeed, this is what any technical analysis worth its name consists of. Add to this the fact that monetarist theory/ orthodoxy exists as a very powerful tool for the Fed to manipulate investor expectations [as most have bought into it], and you have another reason to be wary of the narrative offering so-called certainties.
Of course, there is a meta-narrative/ analysis going on here in this article. The question being asked is not what Fed policy will mechanically do to the economy [and asset prices with it], but what the policy does to expectations, which is quite another thing [expectations based on monetarist theory]. With changing expectations, investors and speculators are liable to swing one way and then the other. The greatest certainty then will not be either the increase or decrease of asset prices but will be their volatility to both sides [leading to bubble-like price behavior at times as was covered here]. And then this should naturally reflect itself in the price, where you could say that those expectations are ‘priced in’ [on the basis of this, the current extended correction was predictable]. Narrative thus becomes superfluous and can be ‘bracketed out’ of price analysis. If narrative is not bracketed out, it may lead to viewing the asset in question through a distorted lens, where that asset may come to be over-valued or under-valued dependent on your persuasion of choice [hyper-inflation or deflation in that classic and dichotomous ‘debate’].
2] Market Expectations as the Driver of Price
It’s been my intention so far to describe the market swinging between both inflation and deflation expectations as opposed to seeing one or the other of the narratives simply as the driver of price in the market place [the crucial difference here is that when the narrative is internalized prices are thought to be determined by inflationary forces, whereas in fact the narrative tends to [or tries to] determine the behavior of market participants].
Given this view of the market, price will neither explode to the upside, nor crash to the downside. Rather it would develop along very volatile lines, where it first enters into a speculative episode on inflationary expectation [FOMO], and then corrects severely on deflationary expectation [this essentially seen as a variant of FUD]. I was looking for this kind of volatility to play out, within the parameters of the LGC, over a year back here. Over the course of the following year, that outlook has been well corroborated/ confirmed in the price action. In this article, I also touched on how irrational and psychological factors trump the rational/ theoretical ones:
Where some see efficient and rational markets, others see them as perfectly irrational at times. Where some see the wisdom of crowds, others see the madness of them. And of course, it doesn’t need to be an either/ or. Markets could be both at various times - a manic market may become an overly sober and cautious one, before turning manic again. It’s those with ‘the tragic vision’ of human nature [less optimistic than the purely rational one] who will see idiosyncratic and capricious human nature at the heart of all markets, not some giant invisible calculating machine. And so too with the Bitcoin market. As long as one is concerned with the market price of Bitcoin, the driver of that price, especially in an increasingly liquid market, will be the mass of participants who will be primarily motivated by speculative and psychological factors as opposed to purely rational ones. This is where behavioral economics will come to the fore as opposed to quant theory, which, from the perspective outlined above, starts to look a little quaint.
It has also been my contention from the start that the model of an LGC channel would accommodate swings between inflation and deflation expectations, mentioning such here in one of my earliest articles here.:
Deflationary concerns also go some way to explaining the volatile swings in Bitcoin to the downside, which have always been proportional corrections to the previous exponential moves to the upside. As much of BTC investment ostensibly involves buying it as an asset/ inflation hedge, and then again on pure speculation, it’s no surprise that price should correct when uncertainty once again dominates the market, as to either the speculative price, or to the wider macro-economic landscape. Yet, once corrected, the price becomes more sustainable. This pattern of alternating explosive and corrective movements in the price [also seen as cycles] has led to the formation of a converging channel atop of the LGC [figures 1 and 2 above]. An extrapolation of this converging channel then gives you a picture of both eventual price discovery/ stabilization and reducing macro volatility [the convergence of the channel]. The volatility within the parameters of this converging channel are compatible with a market divided uncertainly between two narratives - the fear of missing out [FOMO] creates the spike, and then fear per se [of too high a speculative price] leads to the correction. But in the aggregate, you still see the macro trend of the LGC playing out, and it’s actually these existing deflationary concerns, the fear and uncertainty, that brings the volatile and speculative price back down to earth, or should I say, back to the LGC.
To complete the picture of the macro, an explanation is required as to why it is that Bitcoin should continue to perform in respect of the established trend of the LGC. And this is because besides being an asset [for those with hyper-inflation concerns], Bitcoin is also an alternative currency, a form of money [for those with deflation concerns], albeit a nascent one in a volatile process of capitalization. In deflation, investors seek shelter in the strongest forms of liquidity/ money. Given the problematic nature of conventional currencies today, it would only be reasonable for investors to spread risk further by diversifying the currencies they hold. Just as you’d want to hold some gold, so too you’d consider the qualities of Bitcoin as digital gold. Does this exclude price from going lower? No, but it does include the possibility of a solid floor being put in at some date. And so lastly, to the chart, and how the above speculations may be read into that chart.
3] The Speculative LGC Range Defined by both Inflationary and Deflationary Expectations
As subscribers should well know by now, I subscribe myself to the model of an LGC [Logarithmic Growth Curve]. It is a macro hypothesis with both explanatory and predictive functions… and is further corroborated/ confirmed as the predicted price action plays out in real time. Needless to say, it has performed very well these past few years. If the curve is said now to consist primarily of speculative episodes, now that the market is maturing, then the lower and upper parameters of that curve can be said to reflect market sentiment [psychology again] as it swing between the ‘FOMO’ of inflation expectations and the ‘FUD’ of deflation expectations. What’s of interest to note is that the lower range effectively grounds, or solidifies, the speculative excess [without which this burgeoning currency could not be capitalized]. Personally, I think it better to call this grounding a correction as opposed to a bear market, for in calling it a correction the emphasis is on an ongoing dynamic [and larger bull market] that subsumes such corrections into the greater scheme of a larger bull market; namely, the LGC. From a purely technical perspective, this scenario also fits as we see a uniformity to the correction where the real retracements, within the greater LGC channel, has proven to be around 38% each time [ a use of the fib tool in the log function is crucial here]. In other words, there is seemingly a logic at play, and so a model you can have confidence [if not certainty] in. Given the curve, deflation expectation is already ‘price in’ despite the threat that some would think deflation poses. The curve effectively functions, as a model, to both curb enthusiasm on the upside [due to hyper-inflation expectations] and fear on the downside due to deflation expectations. In a word, it is realistic avoiding both overly optimistic [bull] and overly pessimistic [bear] readings.
The reader after having read the above, may be a little rattled by my questioning of certain narratives/ orthodoxies. And then aren’t I just providing yet another narrative**? But this would be to miss the point. The point of the article, indeed most of them, is to open up a questioning and critical space that distances itself from the conventional narratives/ certainties. Remember, a contrarian approach is your competitive advantage in markets. As opposed to providing another narrative to buy into, the article is all about fostering an enlightened skepticism toward all narratives. I think it’s this kind of moderate skepticism that is largely missed in the modern mix of today, where we are all very apt to pin our colors to this or that. Of course, participating in markets does require some kind of decisiveness and expectation insofar as we hope to profit from it. However, that participation should be very much informed by hedging, diversification, uncertainty and pragmatism on the one hand, and the trend of the chart on the other. The pragmatic trader/ investor will not be driven this way or that on the basis of an over-riding narrative, whether that narrative be the siren of hyper-inflation, or the Cassandra of a hyper-deflation.
For more on investing and trading the alt coins, feel free to enquire via a DM to my Twitter account - @davthewave
Until next time,
Stay [relatively] safe out there,
Dave the Wave.
**The reader may be wondering whether the LGC model is not itself a narrative. And rest-assured it is not. Rather, it is a testable hypothesis, one to be validated or not by concrete experience as time rolls on - it lives or dies on its fruitfulness and predictive capability, where it is itself very much grounded by the chart. Where narrative has marketing [and propaganda] qualities to it, where its popularity and trendiness buoy it along, hypothesis is only ever a provisional truth always open to be tested and falsified/ invalidated by experience. The difference between narrative and hypothesis/ modelling is largely the difference between rationality and irrationality. Remember, most pushing a narrative are also looking to push/ hype price. It performs primarily an ideological/ psychological function, not a critical/ rational one.