Hedging inflation expectations in the cryptocurrency futures market

Abstract

This paper finds the first evidence of time variation in the relationship between inflation expectations and the price of cryptocurrency futures. Daily data on the futures markets of Bitcoin – starting in December 2017 – and Ethereum – available since February 2021 – reveal responses to inflation expectations that are consistently positive across both measures in a full sample encompassing 2022. These results hold for a sample that precedes the Luna crash in May 13, 2022. However, the response turns negative in the period between the failures of the Luna and FTX crypto exchanges. We find cryptocurrency futures provide an effective hedge against inflation expectations and may provide a hedge against idiosyncratic market risk if the ensuing uncertainty is embraced by traders leading them to search-for-yield behavior. Risk that is more systemic – and not properly digested by financial markets – may lead futures contract holders to exit their positions ahead of expiration, leading to a bid down of futures prices and an erosion of their hedging ability. This may have contributed to the turbulence in cryptocurrencies experienced during the latter part of 2022.