What are the effects of Fed interest rates on crypto holders?
What are the effects of Fed interest rates on crypto holders
Changes in interest rates affect cryptocurrency prices through changes in investor behavior and market dynamics.
The United States Federal Reserve, or Fed, acts as the central bank of the United States. One of its main responsibilities is to manage the country's interest rates, which essentially controls the cost of borrowing money. A low interest rate makes borrowing cheaper, increases economic liquidity and stimulates consumer spending and investment. In contrast, raising interest rates discourages borrowing, reduces the amount of money flowing through the economy, and slows the economy, aiming to reduce inflation.
Stocks, bonds, and even cryptocurrencies tend to react adversely to interest rates. As a general rule, the interest rate can be viewed as a common denominator used to price assets. If this denominator increases in value, most assets will decrease in price and vice versa. Therefore, cryptocurrencies and non-fungible tokens (NFTs) are no exception to this.
From a behavioral perspective, when rates are low, banks offer lower savings rates. As a result, investors are more likely to seek riskier assets such as venture capital and crypto to achieve higher returns. This increased demand could increase crypto prices. On the other hand, rising interest rates make safe haven assets such as savings accounts and bonds more attractive, diverting investments away from riskier ventures such as cryptocurrencies, potentially leading to price declines.
The impact of interest rates is especially evident on risky assets. Cryptocurrencies, with their inherent volatility and lack of established financial history, are particularly sensitive to changes in the interest rate environment. This is proven by historical price action in the cryptocurrency market. As the price of cryptocurrencies drops, liquidity leaves decentralized finance (DeFi) protocols and blockchain ecosystems begin to look like ghost towns without many users or transactions.
While historical trends are not always direct, they do play out in the broader cryptocurrency, NFT and DeFi markets, underscoring the impact of interest rates on Bitcoin's price dynamics.
Bitcoin (BTC), the largest cryptocurrency by market cap, has had a complicated relationship with the Fed's interest rate decisions. Although the correlation is not always perfect, historical trends paint a clear picture. The impact of interest rates on Bitcoin prices has a cascading effect across the crypto, NFTs, and DeFi markets.
Rewind to 2018
According to then-Chair Janet Yellen, the Fed launched a series of rate hikes aimed at easing inflation concerns. This period coincided with a dramatic decline in Bitcoin's price. From a peak of nearly $20,000 in December 2017, Bitcoin fell to $3,200 by December 2018, a staggering loss of over 80%.
As the price of Bitcoin fell, so did the entire cryptocurrency asset class. While other factors such as currency hedging and regulatory uncertainty played a role, the rising interest rate environment undoubtedly contributed greatly to this crypto winter.
Fast forward to 2021
Buoyed by the Fed's ultra-low interest rates implemented during the pandemic, Bitcoin broke a record above $68,000 in November 2021. Several experts called for a $100,000 Bitcoin price and euphoria was at its peak.
However, a shift in the Fed's stance on interest rates and broader monetary policy began in late 2021. With inflation concerns re-emerging, the Fed has signaled its intention to raise interest rates and reduce liquidity within the economy. This hawkish reversal triggered a significant correction in the crypto market in the coming months. By June 2022, Bitcoin had shed more than 70% of its value below $20,000 once again.
Rising interest rates tend to reduce the crypto market as investor risk appetite decreases, opportunity cost increases, and margin calls increase, leading to price declines and bankruptcies.
Decreased investor risk appetite
As mentioned earlier, rising interest rates make safe asset holdings such as bonds more attractive. Investors seeking higher returns may be less willing to take a chance on volatile cryptocurrencies when they can get a guaranteed return from lower-risk AAA-rated government bonds.
Low-risk AAA government bonds are debt securities issued by governments with the highest credit ratings and provide reliable income with minimal risk of default. This shift in investor sentiment could cause demand for cryptocurrencies to decline and prices to decline.
Increasing opportunity cost
When interest rates rise, the potential returns from holding cash or other interest-earning assets become more attractive. This increases the opportunity cost of holding riskier assets such as equity, venture capital and crypto.
Merge calls and remove the pain
The cryptocurrency market thrives on leverage, where investors borrow money to magnify their potential gains. However, rising interest rates make these loans more expensive. In a downturn, investors could face margin calls, forcing them to sell their crypto assets to meet obligations. This forced selling could increase price declines.
Rising crypto prices resulting from rising interest rates and rising margin calls resulting in several bankruptcies such as Celsius and FTX are expected throughout 2022.
So what are the counter arguments surrounding the impact of Fed interest rates on crypto holders?
Short-term fluctuations in Fed policy may have less of an impact on long-term crypto investors as they believe in the long-term potential of cryptocurrencies and are willing to ride out periods of volatility.
Additionally, Fed actions that could destabilize the traditional financial system could increase distrust in fiat currencies. This could benefit cryptocurrencies in the long run, as some see them as an alternative to government-backed money.
Additionally, certain cryptocurrencies still hedge inflation risk if rising interest rates are accompanied by persistently high inflation. This is especially true for cryptocurrencies with limited supply inflationary adjustment. These factors create complexity, implying that an increase in the Federal Reserve's interest rates could negatively impact the cryptocurrency, while the long-term relationship is far from certain.
Regardless, the Fed's interest rate decisions will undoubtedly continue to play an important role in the future of the crypto market. While the short-term impact may appear negative, a more stable interest rate environment could spur long-term growth for the industry. Only time will tell how the complex interaction between the Fed and the crypto market develops. However, understanding this relationship is crucial for anyone considering entering the world of cryptocurrencies.
