Bitcoin Inflation-Hedge Theory Brings Market Turmoil As Interest Rates Rise

The US economy has been in turmoil lately, with US personal consumption expenditure (PCE) inflation rising 3.5% over the past 12 months. Even excluding the volatile food and energy sectors, the U.S. Federal Reserve's efforts to curb inflation clearly fell short of its 2 percent target.

US Treasuries lost $1.5 trillion in value primarily due to these rate hikes. This has led investors to question whether riskier assets, including Bitcoin (BTC) and the stock market, will succumb to higher interest rates and monetary policy aimed at slowing economic growth.

As the U.S. Treasury continues to flood the market with debt, exacerbating losses for fixed-income investors, rates are likely to rise further. An additional $8 trillion in government debt is expected to grow over the next 12 months, contributing to financial instability.

Daniel Porto, head of Diaglo London, told Reuters:

“(The Fed) is going to play an inflationary game, but the big question is, can we sustain this course without doing too much damage?”

Porto's comments echo a growing concern in financial circles — fears that the central bank could tighten its policies to the point of causing significant damage to the financial system.

High interest rates will eventually lead to disastrous results

One of the main causes of recent volatility in the financial markets has been the rise in interest rates. When rates rise, the value of existing bonds falls, an event known as interest rate risk or duration. This risk is not limited to certain groups – it affects countries, banks, companies, individuals and anyone who holds fixed income assets.

The Dow Jones Industrial Average fell 6.6% in September alone. In addition, the yield on US 10-year bonds rose to 4.7% on September 28, marking the highest level since August 2007. This rise in yields shows that investors are more hesitant to take on the risk of holding long-term bonds. Even those issued by the government itself.

Banks that lend short-term instruments and lend long-term are particularly vulnerable in this area. They rely on deposits and often hold Treasurys as reserve assets.

As Treasurys depreciate, banks may find they lack the funds necessary to meet withdrawal requests. This would force them to sell Treasurys and other assets, dangerously pushing them into bankruptcy and requiring bailouts by institutions like the Federal Deposit Insurance Corporation or big banks. The collapse of Silicon Valley Bank, First Republic Bank, and Signature Bank serves as a warning of financial system instability.

The Federal Reserve's shadow intervention may be close to exhaustion.

While emergency measures such as the Federal Reserve's Emergency Loan Bank Term Funding Program may provide some relief by allowing banks to post defaulted Treasuries as collateral, these measures will not make the losses disappear dramatically.

Banks are increasingly offloading their holdings into private equity and hedge funds, as these sectors are flooded with affordable assets. This trend is set to worsen if the debt ceiling is raised to avoid a government shutdown, increase output and increase losses in fixed income markets.

As long as interest rates remain high, the risk of financial instability increases, prompting the Federal Reserve to use emergency credit lines to support the financial system. That's especially important for a handful of assets like Bitcoin, weighed down by rising inflation and a worsening Federal Reserve balance sheet weighing $1.5 trillion in paper losses on US Treasuries.

It is almost impossible to time this event, let alone what would happen if the big banks tightened the financial system or if the Federal Reserve effectively guaranteed the flow of money to troubled financial institutions. Still, there is never a case where one would give up on Bitcoin in those circumstances.

This article is not intended for general information purposes and should not be construed as legal or investment advice. The views, ideas and opinions expressed herein are solely those of the author and do not necessarily represent the views and opinions of Cointelegraph.