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3 Important Factors Driving the Price of Bitcoin

Thomas Yeung
·5 mins read

Where will bitcoin price go in 2021? Traditional investors have long wondered how to value bitcoin. Few have made headway: unlike stocks or commodities, cryptocurrencies have no earnings estimates or growth projections for investors to lean on.

So, what drives bitcoin price?

The answer may surprise investors because of what’s not included: gold and bitcoin mining supply.

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

Instead, bitcoin prices are controlled by three critical demand-side factors:

Cryptocurrency demand Risk-taking appetite Technical factors

Armed with the facts, we’ll examine how these factors will drive prices in 2021.

And if you want to learn more about investing in bitcoin, learn more in my Ultimate Guide to Bitcoin.

Why Bitcoin?

Firstly, why should investors even consider bitcoin? Simple. $10,000 invested in bitcoin in 2015 would have turned to over $430,000 today. And more gains could still come.

Bitcoin is now the world’s sixth-largest currency. It’s more widely circulated than the British pound and has a trading velocity six times the U.S. dollar. Bitcoin is also the primary currency of cryptocurrency developers, an essential step to getting venture capital (VC) dollars and attention.

BTC Market Share on CoinMarketCap
BTC Market Share on CoinMarketCap

Source: Chart by InvestorPlace, Data courtesy of CoinMarketCap

Bitcoin makes up the largest share of all crytocurrencies

Now onto valuing bitcoin

What Drives Bitcoin Price?

Not fundamental valuations…

Traditional investors have often tried to develop an “intrinsic value” of bitcoin by analyzing its supply.

But that method misses one key fact: bitcoin’s supply remains relatively fixed because of its underlying code. The blockchain caps the maximum number of coins to 21 million. And a self-adjusting difficulty function means cryptocurrency miners have little effect on the speed of mining, unlike in gold or other producible commodities.

BTC - Mining Difficulty Aug 2020
BTC - Mining Difficulty Aug 2020

Source: Data courtesy of Blockchain Charts

So what drives bitcoin prices in the short-term?

Driver 1: Cryptocurrency Demand

What assets are bitcoin returns most correlated to?

Other cryptocurrencies.

Even though the three top cryptocurrencies (bitcoin (BTC), Ethereum (ETH) and Ripple (XRP)) run on fundamentally different technologies, correlations between them have jumped since 2017. Today, bitcoin has a 0.9 correlation with both Ethereum and XRP, meaning they move together 90% of the time.

BTC - Graph of XRP ETH and Bitcoin Price Correlations Aug 2020
BTC - Graph of XRP ETH and Bitcoin Price Correlations Aug 2020

Source: Data courtesy of Yahoo Finance

Cryptocurrency correlations have risen over time

Essentially, investors have started to view cryptocurrencies as a single asset class.

Technology has undoubtedly played a helping hand. Gone are the days of setting up individual wallets for each currency. Coinbase and Robinhood, two major U.S. cryptocurrency platforms, now offer side-by-side comparisons of various coins. Investors can also easily buy index-linked products.

Driver 2: Risk-taking appetite

What about comparisons to gold? Do investors also see bitcoin as an inflation hedge and a safe-haven asset class?

The data says “no.”

Bitcoin returns are only 9% correlated with gold, a positive but relatively insignificant amount.

Instead, the cryptocurrency has far more in common with risky assets.

  • S&P 500: 22% correlation

  • Junk Bonds: 19% correlation

  • VIX (S&P volatility): -16% correlation (i.e., bitcoin prices decrease in volatile markets)

So, contrary to common beliefs, bitcoin doesn’t act as a safe-haven asset. Instead, it does the opposite: its value tends to go up in confident bull markets and fall in fearful bearish ones.

BTC - Graph of SNP and Bitcoin Price Returns Aug 2020
BTC - Graph of SNP and Bitcoin Price Returns Aug 2020

Source: Data courtesy of Yahoo Finance

Driver 3: Technical Factors

Technical analysis requires less efficient markets to work. A study by the U.S. Federal Reserve found that technical analysis in the foreign exchange market worked during the 1970s and ’80s, but declined in the ’90s as information flows improved.

Fortunately for cryptocurrency investors, BTC today still resembles the inefficient systems of the 1970s.

Bitcoin trades on multiple disconnected exchanges, making it difficult to determine its exact price at any given moment. And investors still routinely accuse market makers of manipulating prices. These factors make trend-following an essential tool in tracking the self-reinforcing prophecies of bitcoin price.

That’s meant technical strategies have worked on bitcoin. Below is a graph of RSI-14, a standard mean-reversion indicator.

BTC - RSI Buy-Sell Signals Graph of Bitcoin Price Aug 2020
BTC - RSI Buy-Sell Signals Graph of Bitcoin Price Aug 2020

Source: Data courtesy of Yahoo Finance

RSI-14 has performed well in tracking BTC buy and sell points

An investor using these indicators would have generated 15% higher returns than buy-and-hold while invested just 40% of the time. A more aggressive approach would have pushed returns even higher.

How to Invest in Bitcoin for 2021

Bitcoin’s three key drivers mean one thing for 2021: bitcoin prices will depend on the economy.

  • Fast-improving economy. Cryptocurrency demand increases, risk-taking up, technical factors positive. Bitcoin rises to $15,000 – $20,000.

  • Slowing economy. Lower cryptocurrency demand, flight to safety, negative technical factors. Bitcoin falls to RSI resistance levels of $5,800 – $9,000

Which path with bitcoin take? In an August research note, Goldman Sachs’ Global Research team struck an upbeat tone for the 2021 economy.

“We now expect that at least one vaccine will be approved by the end of 2020 and will be widely distributed by the end of 2021Q2,” Goldman Sachs economist Joseph Briggs wrote. “We have incorporated this timeline as our baseline forecast, and now assume consumer services spending accelerates in the first half of 2021 as consumers resume activities that would previously have exposed them to Covid-19 risk.”

If these expectations play out, bitcoin investors will see good times ahead. But if the economy suddenly grinds to a halt, then bitcoin price will certainly fall.

Bitcoin Price Beyond 2021

As trading matures, technical factors will eventually take a backseat in determining bitcoin price.

In their place, fundamental factors will start to take over: matters such as transaction fees, forks, user adoption, and the general demand for cryptocurrencies. My colleagues at InvestorPlace have a friendly bet: which will reach 40,000 first: bitcoin or the Dow Jones? And either could be right.

But for 2021, how to invest in bitcoin remains clear. As political consultant James Carville once said, “it’s the economy, stupid.”

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

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