The Dollar’s Demise And Bitcoin’s Rise

One of the questions investors have been asking lately concerns the outlook for the U.S. dollar index. Investors are understandably concerned by the dollar’s weakness and worry that perhaps that any notable increase in inflation could lead to further erosion in the dollar’s value.

In a weak dollar environment, investors actively search for alternatives to cash which provide growth and relative protection from dollar weakness. Until 2011 the investment safe havens of choice were gold and silver; prior to that it was real estate. The new alternative investment versus the dollar is growing in popularity and becoming more widely accepted as a legitimate financial vehicle. I’m referring to Bitcoins, the open-source, peer-to-peer payment network and digital currency.

Bitcoins made news recent when the People’s Bank of China announced that it was prohibiting Chinese financial banks from accepting Bitcoins as legal tender currency. The announcement caused a 20 percent drop in the value of Bitcoins, though the value later rebounded. Bitcoins have been one of the big financial success stories of the year, and the continued increase in the coin’s value has prompted speculation that a “Bitcoin bubble” has developed.

Randall Forsyth, writing in a recent Barron’s column, nailed it down when he wrote: “Clearly, [Bitcoin] is a speculative vehicle for the masses.” Another Barron’s writer, Michael Kahn, likened Bitcoin’s bull market to the tulip mania of 1637. “The dangers of buying into a bubble,” he wrote, “are the same as attempting to sell it short. It could double from here, just as easily as it could fall by half.”

Others believe that Bitcoin’s success and soaring value represent a repudiation of the weak U.S. dollar. It’s no coincidence that Bitcoin’s popularity has greatly increased in the wake of the gold bear market; Bitcoins have apparently supplanted the yellow metal as a safe haven du jour among libertarians and others worried about a potential dollar collapse.

Evaluating the Bitcoin’s value is a difficult task. Regardless of the metric, whether fundamental or technically based, analysis of Bitcoins is a tall order without something with which to make relative comparisons. The lack of long-term historical price data is another impediment to making informed risk assessments regarding Bitcoin’s future. David Woo, currency strategist at Bank of America Merrill Lynch, recently published a valuation report on Bitcoin. He valued the digital currency at $1,300, cautiously adding that this number is based on several assumptions that can’t be firmly quantified.

Woo concluded that the rapid growth of the digital currency’s value “would suggest the price appreciation has been more about Bitcoin as a store of value or investment than as a medium of exchange.” He also noted that Bitcoin transactions have diminished as the coin’s price has increased.

An examination of the Bitcoin “long-term” chart is revealing. Any market technician worth his salt will preface an analysis of this chart by pointing out that, aside from transaction volume, there is little data with which to make an informed forecast other than price itself. That said, a classical chart pattern analysis suggests there is more upside in the coin’s future before the bull market in its value comes to an end. The breakout to new highs in Bitcoin’s price which occurred in November was preceded by six months of base-building; in classical chart analysis this is normally a good indication of a significant upside run ahead. Below is a weekly chart for the Bitcoin.


courtesy of www.bitcoincharts.com

As a speculative medium, Bitcoin is an undisputed success. As a medium of exchange, the currency has been less than ideal. The serious shortcomings of Bitcoin as a dollar substitute were chronicled in an amusing article by Jessica Roy in a recent issue of Time magazine. As she pointed out, “Very few brick-and-mortar stores actually accept bitcoins today.” And for the ones that do, the transactions can be exceedingly complex and time consuming.

While there may be additional upside ahead for Bitcoin’s value in the intermediate term, the ultimate fate of Bitcoin is likely to be that of every other dollar hedge we’ve seen in recent years, namely a collapsed value.

Returning to our analysis of the dollar, while the dollar index has been weak in recent months there is reason to believe we’ll see a meaningful rally at some point in 2014. If expectations of a stock market melt-up and subsequent melt-down is realized it will almost certainly be accompanied by a major dollar rally owing to investors’ needs to get liquid. Moreover, since the end of the credit crisis dollar rallies have been bi-annual affairs and since 2013 was mostly a down year for the dollar, 2014 should see a rally assuming this relationship remains alive.